The London Interbank Offered Rate (LIBOR) has been the benchmark for setting interest rates between banks since the 1970s. It has served as a common standard by which the interest rate of adjustable-rate mortgages (ARMs), among other types of loans, is set, often through specific contractual terms.
With LIBOR set to end as the interbank rate benchmark in June, John Levonick, regulatory compliance attorney and CEO of Canopy Financial Technology Partners, spoke with Dodd Frank Update about the transition and some things mortgage servicers should expect.
A lot of focus is on ARMs, Levonick explained. ARMs come in different forms: some are adjusted annually, and some can adjust every six months, every three months, or every month, depending on how aggressive these products are.
“When the mortgage payment adjusts, the contract will dictate the terms for how a borrower’s payment is calculated,” Levonick said. “The payment will be index plus margin, and for the benchmark index we are talking about LIBOR, which historically has been the most popular benchmark index.”
The LIBOR Act, passed by Congress in 2022, ordered the Federal Reserve Board of Governors to select a replacement benchmark which could function as a substitute for LIBOR in legacy contracts. The law distinguished between three categories of LIBOR contracts with different types of fallback provisions.
The first category of LIBOR contracts is those which contain a fallback provision identifying a specific benchmark replacement that is not based in any way on LIBOR. These contracts are expected to transition to the contractually agreed upon replacement benchmark as provided by the fallback provision on or before June 30.
The second category encompasses LIBOR contracts that contain no fallback provisions, as well as LIBOR contracts with fallback provisions that do not identify a determining person – the person who would be responsible for determining the replacement benchmark – and that only identify a benchmark replacement that is based in any way on USD LIBOR values or require that a person conduct a poll, survey, or inquiries for quotes or information concerning interbank lending or deposit rates.
For this second category, the LIBOR Act provided the benchmark replacement after June 30 will be the board-selected benchmark replacement which must be based on the Secured Overnight Financial Rate (SOFR) and include the tenor spread adjustments required under the LIBOR Act. Therefore, any references to USD LIBOR in LIBOR contracts in this second category will, by operation of law, be replaced by a SOFR-based benchmark.
The third category of LIBOR contracts encompasses those that contain fallback provisions authorizing a determining person to determine a benchmark replacement.
“There are a bunch of legacy contracts, legacy bonds, securitizations, mortgages, that reference LIBOR that stipulate if LIBOR is no longer in existence, [the issuer] reserves the right to determine what will replace that and will let you know what that is,” Levonick said.
The application of the LIBOR Act to LIBOR contracts in this third category depends on the determination, if any, made by the determining person. Where a designated, determining person does not select a replacement for LIBOR by either June 30 or the latest date for selecting a benchmark replacement according to the terms of the contract (whichever is earlier), the LIBOR Act provides the benchmark replacement will be, by operation of law, the board-selected benchmark replacement.
Should a determining person choose the board-selected benchmark replacement as the benchmark replacement, the LIBOR Act provides that such selection shall be:
- Irrevocable.
- Made by the latest date for selecting a benchmark replacement according to the terms of the LIBOR contract or before June 30, whichever is earlier.
- Used in any determinations of the benchmark under or with respect to the LIBOR contract occurring on and after the LIBOR replacement date.
“As a mortgage holder of an adjustable-rate product, there has to be trust that the servicer sends them the monthly statement that accurately indicates the readjustment of the monthly payment,” Levonick said. “That way there is not a lot of fear from the marketplace on concerns of pushback from consumers. The obligation is on the mortgage servicers to ensure the new benchmark index is incorporated correctly.”
Levonick warned of the potential ramifications of failing to correctly change over legacy LIBOR loans to the detriment of the borrower. If a loan issuer or servicer fails to correctly change over a legacy LIBOR contract to whatever benchmark they may choose or fails to adequately notify the borrower of the changeover, there may be consequences.
“They’ll have to correct the amount. If their calculations resulted in an amount that was greater than what the borrower should have paid, that's a big ‘no-no,’” Levonick said. “They'll have to pay that money back.”
Levonick continued: “In the event that a mortgage goes to foreclosure in the future, and the borrower puts on a defense to that foreclosure arguing they were overpaying on the mortgage this whole time because the servicer was miscalculating your payment, that could potentially stop a debt holder or prevent a debt holder from foreclosing.”
Although the LIBOR Act does not require a determining person to choose the board-selected SOFR benchmark replacement, the LIBOR Act does offer some safe harbors for those servicers that opt for the board-selected SOFR benchmark, Levonick noted.
These safe harbors include restrictions that a determining person “generally shall not be subject to any claim or cause of action in law or equity or request for equitable relief, or have liability for damages, arising out of the selection of the board-selected benchmark replacement as a benchmark replacement.”
“Servicers had better be moving sooner rather than later. They better be testing their systems, because when it matters, they better be doing it right. There’s very little margin for error here,” Levonick cautioned. “When the consumer could potentially negatively be impacted and their payment goes way up, and they’re not able to afford it anymore, but it’s based on an error by the servicer, that’s going to be headline news and no bank or service wants to be in the headline for that.”